'Benign currency neglect' could spell real danger for US economy

What's happening to the dollar? That's the question dominating the world's
financial markets. Last week the US currency fell, on a trade-weighted
basis, to a fresh 14-month low. The dollar's decline is now gaining momentum.

Many American economists say the greenback is falling because the global economy is recovering – so investors no longer need the dollar as a "safe haven".

That's nonsense. The reality is that "safe haven" status has shifted away from the dollar and towards tangible assets that the US government can't debauch by printing more of them.

That's why gold just hit a fresh all-time high of well over $1,000 per ounce. That's why commodity-backed currencies like the Australian dollar are now soaring – causing howls of protest from Aussie exporters. Meanwhile, global investors are quitting the US currency because they're worried it's a sinking ship.

It's hard to disagree. America is still running a current account deficit equal to almost 3pc of national income. In a single month over the summer, the gap between America's imports and exports widened no less than 16pc.

America's external imbalance remains sizeable in part because the country is the world's biggest oil importer. When crude prices rise, Uncle Sam's trade deficit increases, which, in turn, pushes down on the dollar.

As every financial analyst knows, a falling dollar means rising oil as the black stuff is priced in US currency. But the relationship also operates in reverse. When oil strengthens, the dollar tends to weaken as America's trade deficit suffers. Crude is now more than 50pc above its mid-February low – ergo, a weaker dollar.

The dollar is also falling because that's what the White House wants. "It's important America continues to have a strong currency," said US Treasury Secretary Timothy Geithner last week. "We've made clear our commitment to a strong dollar," added Larry Summers, the Head of President Obama's National Economic Council.

These men insult our intelligence. The US government desperately wants a weaker dollar – so boosting exports while lowering the value of America's massive foreign debt. The currency markets will keep betting against the greenback as they know the Federal Reserve will do nothing to stop a weaker dollar coming true. "Benign currency neglect" is the cornerstone of Obama's recovery strategy.

The danger is, though, that "the rope slips" and steady decline turns into nosedive. If the dollar did tip into free fall, US inflation would soar and interest rates would skyrocket – whatever the Fed now says. The world's largest economy would then face "stagflation" – the nightmare combination of recession and high inflation.

This danger is very real, not least because the rest of the world is seriously concerned at America's wildly expansionary fiscal and monetary policy. That's the fundamental reason the dollar is falling.

Just over a year ago, America's monetary base was equal to 6pc of national income. Now, after a year of money printing, it's 12pc. The US has expanded its basic money supply by a staggering 108pc in 12 months. No wonder the currency markets are alarmed about future US inflation. No wonder there is a widespread assumption so-called "quantitative easing" – or QE – will continue, funding yet more bank bailouts and other forms of wasteful government spending.

On top of all this, we must now add "carry trade" pressures. As this column pointed out last month, investors are using low Fed rates to take out inexpensive dollar loans, then converting the money into higher-yielding currencies. "Carrying" credit in this way is flooding the world with cheap dollars – pushing the greenback down even more.

There are broader reasons for the dollar's demise – not least that the sun is now setting on its reserve currency status, as the world's commercial centre of gravity shifts towards the emerging giants of the East. That's a much longer-term trend, though. In the here and now, the dollar is tumbling due to America's ultra-low interest rates, monetary incontinence and fiscal irresponsibility.

The decline became so steep last week that central banks in Asia – including China – spent their own reserves propping up the US currency, so worried were they about the impact of the falling dollar on their all-important exports. Future historians will shake their heads in disbelief.

Keep in mind, though, that the arguments pointing to a weaker dollar also apply to the pound – but even more so. Last week sterling hit a trade-weighted five-month low. Over the last year, the pound has, well, been pounded – losing significant ground against the yen and euro, as well as the ailing dollar.

Like the US, Britain has indulged in grotesque money-printing antics. The two countries might be dubbed the QE2. But the Bank of England's printing presses really have been in overdrive, with the UK's monetary base now equal to almost a fifth of GDP, up a head-spinning 169pc in a single year.